Disallowances and Overcapitalization in the U.S. Electric Utility Industry

Regulation of an industry often produces unintended consequences. Averch and Johnson (1962) argue that certain regulation of electric utilities provides utilities the incentive to purchase an inefficiently large amount of capital. Another possible and related unintended consequence of electric utility regulation is that regulatory cost disallowances on capital may also increase utilities' incentives to overcapitalize. The authors provide theoretical evidence that capital expenditure disallowances will increase the Averch and Johnson effect in some instances and thus may have contributed to the overcapitalization problem that regulation was designed to discourage. Our model shows that disallowances can reduce the rate of return on investment and thereby increase the Averch and Johnson distortion. (JEL D42, L43, L51)

All households, firms, and government entities depend on one or more of the 3,170 electric utilities in the United States to provide a reliable source of energy. These electric companies consist of investor-owned, publicly owned, cooperative, and federal utilities.1 Only 8 percent of these utilities are investor owned, but they produce approximately 75 percent of the total generating capability. Publicly owned and federal utilities each generate about 10 percent of the country's electricity, and cooperatives generate the remaining 4 percent. The revenue from retail sales (to ultimate consumers) for all electric utilities amounted to $326 billion in 2006 and represents about 2.5 percent of gross domestic product.

The industry increased output by 20 percent from 1995 to 2006, and generation capacity is expected to grow by another 8 percent over the next five years. Currently, nearly 98 percent of the existing capacity consists of fossil fuel power plants, nuclear reactors, hydroelectric power plants, and other renewable energy sources.2 Although these sources all contribute to the total generation, fossil fuels generate the majority of electricity. Natural gas, coal, and petroleum supply 41 percent, 31 percent, and 6 percent of generation capabilities, respectively. Nuclear, hydroelectric, and other renewable sources comprise approxi- mately 19 percent.3 To date, the academic litera- ture has devoted much attention to the U.S. electric utility industry. The primary reason for such interest is that electricity is used by all Americans, and firms in the industry enjoy a monopolistic market structure, at least at the distribution level. Although the academic literature is broad in scope, most articles fall into two categories. The first category is cost analysis - primarily the measuring of scale economies. That is, researchers attempt to determine where firms are operating on their longrun average cost curves and subsequently determine whether production costs can be lowered by having firms increase or decrease their scale of production. The second category, much larger than the first, is analysis of the regulatory aspect of the industry and the unanticipated consequences of those regulations. Relevant regulations involve not only those related to the environmental impact of electricity generation but also those regulating profits by setting the price that firms are allowed to charge for their electricity.

One specific issue that has sparked much attention is the overcapitalization of the electric utility industry - that is, electric utilities hold a quantity of capital that is greater than the costminimizing quantity. Averch and Johnson (1962; hereafter A-J) argued that privately owned utilities invest in capital beyond the cost-minimizing level in response to the incentives offered by regulation. The authors showed how a regulator, by tying a firm's allowed profit to its capital stock and offering a rate of return on capital that exceeds the marginal cost of capital, provides the firm the incentive to purchase an inefficiently large amount of capital. …

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